Educational Articles

Corporate Governance Basics

Warren Thorpe
| August 04, 2011

In the late 1990s, the former CEO of Tyco (TYC) Dennis Kozlowski allegedly1 used more than $135 million from the corporate coffers to buy, among other things, a 15,000 square-foot Florida mansion and fill it (and his Manhattan apartment) with art, antiques, and over-indulgent luxuries, such as a $6,000 gold-and-burgundy floral patterned show curtain.

In October of 2001, it was revealed that the management at Enron had deliberately misled the public about its operations and finances. In order to please investors, earnings and cash flows were routinely inflated through fudged accounting and the use of complex off-balance-sheet transactions. When this came to light, the stock plummeted and, just a couple of months later, the company went bankrupt. Shareholders lost an estimated $60 billion, and 15,000 employees lost their jobs and $2 billion in pension money almost overnight.

These egregious examples, along with a number of other high-profile corporate scandals, resulted in a major overall of the regulatory landscape (Sarbanes-Oxley Act), including the practices of corporate governance (GC).

GC is a system of rules and guidelines aimed to minimize or eliminate the conflicts of interest inherent in the modern, public corporation, in which ownership is typically diffuse and a separation exists between managers and owners (i.e., shareholders). Indeed, the average investor holds a proportionally small stake in a company and is distant from, and often plays no role in, corporate decisions. Professional managers are the ones that control and deploy corporate assets. They are tasked to do so with consideration to shareholders’ interests, but if managers are selfishly motivated, they may, instead, act to increase their own salary, benefits, or job security, at the cost of the stockholders.

Unfortunately, it can be rather difficult to detect if a company is failing to adhere to good GC. Some information is just not available. For example, investors aren’t privy to a company’s internal controls. There are some things, however, that one can do. A good source is the corporate Web site, noted in the Business Description section of every Value Line stock report. Often companies will outline GC and code of ethics policies there. General Electric’s (GE - Free General Electric Stock Report) governance page is a very good example.

Information can also usually be found in the most recent Proxy Statement (form DEF 14A), the annual report, or the 10-K filing, found on the SEC’s Website. For European companies, the annual report usually provides some information.

Board of Directors

Good GC relies on a system of checks and balances between the managers and investors. The board of directors plays a critical role here. The following are some examples of good GC practice with respect to the board functions:

1. The roles of CEO and Chairman of the Board are not held by the same person. This information can be found in the Business Description section of Value Line stock reports. Unfortunately, it is not uncommon in the United States for these roles to be combined. If they are, it is best if the board contains a “lead” independent director with specific responsibilities to ensure independent oversight of management. This is the policy of discount-store chain operator Target (TGT).

2. A majority of board members are independent. At least a majority of members should neither be company management nor cronies or relations of management. These last two can be harder to determine, but often the members’ biographies can be revealing.

3. The subcommittees are entirely independent. It is especially important for the audit committee (overseas accounting and financial reporting) and compensation committees (determines executive pay) to be impartial and have the authority to hire outside consultants if need be.

4. Members’ experience should be relevant. Members should have a level of expertise and experience relevant to the company’s business so as to best serve the interests of the shareholders. Familiarity with strategic planning and risk management is particularly valuable.

5. Executive compensation is subject to “clawback”. It’s generally thought to be beneficial for a portion of executive compensation to be in stock or options. This is a type of performance-based system. Managers may be tempted, however, to break accounting rules in order to artificially inflate earnings (so as to push the stock higher). This is where the clawback comes in. If a later audit reveals those wrongdoings and earnings are consequently restated, executives subject to a clawback policy must pay back the associated compensation, even if they no longer work for the company. This discourages managers from making adjustments just to inflate earnings. Clawback policies appear to be an increasingly popular option.

Accountability

Openness is one of the hallmarks of good GC. Does the company have a reputation of openness and honesty? If you are not familiar with the firm, more digging may be required:

1. Is the company transparent with its published information? Read the corporate news, which can be found by typing in the ticker symbol in the Get Quote field at the top this page. Is management forthright, or do the lenders tend to be more tight-lipped? Studies show that stocks tend to perform better when management is transparent.

2. Listen to the earnings conference calls. Investors can learn a lot from management’s tone and how forthcoming they are in response to analysts’ queries. Access is usually available through the company’s Web site; if not, that could be a red flag. If the company does not even hold conference calls, that may be another flag.

Insider Decision & Holdings

Although not directly related to GC, the Insider Decisions box, found in the upper left hand corner of Value Line stock reports, can be a very useful tool. It shows how many executives at the company have either bought or sold the stock in the past nine months. It provides an indication of the insider’s assessment of both a company’s prospects and those of the stock. Also indicative of this is the insider holdings breakdown located in the Business Description.

In summary, a growing body of evidence suggests that companies with sound corporate governance policies show higher profitability and investment returns than those firms with weaker systems in place. Spending a little time to assess these issues may be beneficial to your portfolio.